November 10, 2015

Quality of earnings should matter more

There are often profound differences in GAAP vs. non-GAAP accounting, especially among technology and social-media companies.

But David Einhorn of Greenlight Capital recently noted that this creates some big questions for investors, writing:

    "Would these companies be able to retain their highly talented workforces if they stopped doling out large amounts of equity? If you are trying to determine the creditworthiness of these ventures, it might make sense to back out non-cash expenses. But if you are an equity holder trying to value the businesses as a multiple of profits, how can you ignore the real cost of future dilution that comes from paying the employees in stock?"

Bull markets are forgiving of non-GAAP accounting -- but in a bull run's later stages, the irrational is often rationalized.

During periods of market optimism, investors rarely stop to reflect on the quality of earnings. They don't bat an eye at a falling effective tax rate, the absence of organic growth (often covered up by a "roll-up" strategy of serial acquisitions) or a vast gap between non-GAAP and GAAP accounting or other bookkeeping conventions.

But as we're learning from Valeant Pharmaceuticals, Sun Edison, some energy MLP's and other stocks, introspection can be painful when the alleged fantasy numbers are discovered.

As I recently wrote on the subject of roll-ups:

    "Zero interest rates, massive liquidity and slow global economic growth breed financial engineering, accelerated M&A activity and the proliferation of 'roll-up' strategies. That's where companies boost earnings not through organic growth, but via acquisitions.

    The breeding ground for roll-ups is a flourishing mid-business-cycle condition, when liquidity is abundant, the stock market is euphoric, there's little introspection and less of a focus on earnings quality.

    But problems often get exposed later in the business cycle. Accounting issues tend to arise toward a bull market's end after companies that used roll-up strategies have problems growing sales and profits further.

    Marginal and/or aggressive executives with questionable business ethics often cut corners and take advantage of accounting conventions. But as the cycle matures and credit markets tighten -- as we're seeing now with widening spreads between investment-grade and high-yield bonds -- roll-ups often turn sour.

    Recent questions surrounding Valeant Pharmaceuticals and SunEdison could be examples of this. For all we know, so could the U.S. Securities and Exchange Commission's investigation of revenue recognition at IBM (IBM - Get Report) . Other firms will likely also face questions as well.

    -- Doug's Daily Diary, A Word About Roll-Ups (Oct. 29, 2015)

Back in June, Barron's Andrew Bary also wrote an excellent article on non-GAAP accounting: How Much Do Silicon Valley Firms Really Earn? And on Sunday, Gretchen Morgenson of The New York Times discussed Valeant's aggressive accounting tactics in this well-documented article.

I was originally turned on to the issue of corporate accounting by Dr. Abraham Briloff. His seminal book, Unaccountable Accounting: Games Accountants Play, and his series of scathing accounting articles in Barron's formed the basis for (and my interest in) the subject of earnings quality. Indeed, I spend much time on this subject in an MBA textbook I'm currently writing.

Technology companies -- emerging and rapidly growing social-media stocks in particular -- are among those that deliver the most aggressive and at times fanciful non-GAAP earnings reports these days.